There is a connection between fiat currencies
and trade deficits, and many cynics have argued that the US dollar's
status as global reserve currency allowed Americans to consume more than
they produced for decades. However, this "deficit without tears"
argument is sometimes overstated. To gain a deeper understanding of both
monetary theory and international trade, it is useful to probe the issue
more carefully.

Does fiat money cause trade deficits?

In his book, The Creature from Jekyll Island, G.
Edward Griffin explains, “When the dollar was separated entirely from
gold in 1971, it ceased being the official IMF world currency and finally
had to compete with other currencies. From that point forward, its value
increasingly became discounted. Nevertheless, it was still the preferred
medium of exchange. Also, the US was one of the safest places in the world
to invest one's money. But, to do so, one first had to convert his native
currency into dollars. These facts gave the US dollar greater value in
international markets than it otherwise would have merited. So, in spite
of the fact that the Federal Reserve was creating huge amounts of money
during this time, the demand for it by foreigners was seemingly limitless.
The result is that America has continued to finance its trade deficit with
fiat money — counterfeit, if you will — a feat which no other nation
in the world could hope to accomplish.”

Griffin then further explains, “There is a dark side
to the exchange, however. As long as the dollar remains in high esteem as
a trade currency, America can continue to spend more than it earns.

But when the day arrives — as it certainly will —
when the dollar tumbles and foreigners no longer want it, the free ride
will be over. When that happens, hundreds of billions of dollars that are
now resting in foreign countries will quickly come back to our shores as
people everywhere in the world attempt to convert them into yet more real
estate, factories, and tangible products. As this flood of dollars bids up
prices, we will finally experience the [price] inflation that should have
been caused in years past.”

Regardless of Griffin's particular stance, there are
definitely some members of the sound-money community who believe that
trade deficits would literally be impossible if all countries were on a
gold standard. That is incorrect, as I will argue in the next section.

Gold does not prevent trade deficits

One quick way to see a puzzle in Griffin's analysis
above is that the reasons for the appeal of the US dollar would only be
enhanced by a return to gold. Griffin says that foreigners still believe
the US was the safest place to invest money. If the Treasury or Fed
credibly announced that henceforth the dollar would once again be
redeemable for a fixed weight of gold, surely investors would flock to it
even more so. It would be much safer to buy a government or even corporate
bond issued in the US knowing that the gold standard would restrain
further dollar creation.

When economists compute the trade balance, they do not
include the sale of financial assets. So if foreign investors want to
spend more (once we convert to a common denominator) on American assets
than US investors want to spend on foreign assets, the trade balance is
negative. The capital-account surplus is counterbalanced by a
current-account deficit.

Tying the dollar to gold, or, better yet, abolishing
the government's involvement in money and banking completely, would make
the US an even stronger magnet for foreign investment. It is possible that
the absolute size of the trade deficit would fall, but it would not
disappear.

In fact, if the US government not only returned the
dollar to gold, but also eliminated the Internal Revenue Service (IRS) and
slashed its budget, it is possible that the US trade deficit would
mushroom. This would make perfect sense, as capital from around the world
would flow to the new haven where its (after-tax) returns would be much
higher.

Unfortunately, there is another possibility. If the
Federal Reserve creates hundreds of billions in new dollars out of thin
air, and the foreign investors are other central banks that gobble up the
dollars because their own rules treat them as reserves, then this increase
in the foreign demand for "American assets" is of a
much-different character.

In particular, the low US interest rates that
accompany such a gusher of new dollars will encourage domestic consumption
and will discourage foreigners in the private sector from investing in the
US. The rest of the world will acquire American assets all right, but they
will be more heavily tilted toward debt (rather than equity in growing
companies). The physical goods flowing into the US will be consumer goods
such as TVs and iPods.

Griffin is perfectly correct that this type of
mushrooming trade deficit is indeed unsustainable as the influx of
consumer electronics does not allow the US economy to produce more in the
future.

The increase in foreign claims on US income streams
therefore is not a constant or shrinking portion of the growing American
pie, but rather is a growing portion of a constant pie. It can be
sustainable for the absolute dollar amount of US corporations' outstanding
bonds to increase over time, so long as earnings and profits increase
proportionately. But it is not sustainable if households and the
government experience a rising debt-to-income level.

Conclusion

There is a definite connection between fiat currencies
and trade deficits. Critics of the Federal Reserve are right to blame it
for distorting trade flows and setting the US economy up for an
inflationary crash. However, a trade deficit per se is not a sign of a bad
economy. Indeed the trade deficit might blossom if the US ever returned to
the gold standard, though it would be due to a productive net inflow of
producer goods.

— [Robert Murphy, an adjunct scholar of the Mises
Institute and a faculty member of the Mises University, runs the blog,
Free Advice, and is the author of The Politically Incorrect Guide to
Capitalism, the Study Guide to Man, Economy, and State with Power and
Market, the Human Action Study Guide, and The Politically Incorrect Guide
to the Great Depression and the New Deal. This article is submitted in
Pakistan by Alternate Solutions Institute Syndication Service, Lahore.
http://asinstitute.org